Published 5:02 am, Friday, February 7, 2014

By Mark Duffy

For many years, taxpayers have struggled to properly categorize amounts paid to acquire, produce or improve tangible property due to lack of comprehensive guidance. Seemingly simple questions such as "should these costs be capitalized or expensed?" can be difficult to answer without the appropriate direction. This issue is of special importance to the oil and gas industry.

The IRS seeks to provide long-awaited clarification in this area with the release of the "Final Capitalization Regulations" (T.D. 9636), effective for tax years on or after Jan. 1, 2014.

These regulations cover a broad spectrum of topics. However, of particular interest is the introduction of a de minimis safe harbor for certain amounts paid for tangible property.

This provision allows taxpayers with accounting procedures in place to uniformly expense certain costs, in addition to many other broad implications for the oil and gas industry.

To provide a better understanding of this safe harbor, it is necessary to understand the definition of a Unit of Property (UOP) and the specific instructions for the de minimis safe harbor election.

The determination to capitalize or expense costs to acquire, produce or improve tangible property begins by determining the individual UOP. A UOP consists of all the components of property that are functionally interdependent. Components are considered to be functionally interdependent if placing one component in service is dependent on another component.

For upstream companies, the determination of a UOP is an important decision that is complicated by the complexity of the industry. Would a well and its components be considered a single UOP, or would the components (e.g. lease and well equipment, compressors, tanks, etc.) be considered individual UOPs? Even basic determinations such as this have a significant impact on a company's utilization of the de minimis safe harbor.

The de minimis safe harbor election provides that amounts paid for a UOP can be expensed if (1) the taxpayer has written accounting procedures in place at the beginning of the year, (2) Applicable Financial Statements (AFS), and (3) the amount per invoice (or item as substantiated by the invoice) does not exceed $5,000. This election is made annually by including a statement on the taxpayer's timely filed tax return for the year, and does not require an application for change in accounting method.

AFS's are required to be filed with the Securities and Exchange Commission (SEC), as a certified audited financial statement (used for credit purposes, reporting to shareholders, partners or similar persons, or any other substantial non-tax purpose), or a financial statement required to be provided to the federal/state government or agency. Taxpayers without an AFS are subject to a lower ceiling for the de minimis safe harbor of $500.

To illustrate this concept, Company A meets the requirements for the de minimis safe harbor and purchases 20 trailers for a total cost of $100,000 ($5,000 each trailer). If Company A elects to apply the de minimis safe harbor, they can expense the entire cost of all 20 trailers.

Additionally, Company A would not be allowed to capitalize any other amounts meeting the criteria for the de minimis safe harbor.

These taxpayers will also need to have accounting procedures in place at the beginning of the year. However, the regulations do not currently specify that these procedures are required to be in writing. The absence of this requirement is perceived by some to be an oversight in drafting the final regulations. Therefore, it would be advisable for non-AFS taxpayers to retain a written policy to substantiate their accounting procedures.

It is important to note that the de minimis safe harbor is not designed to prevent taxpayers from maintaining accounting policies that seek a deduction for amounts in excess of the safe harbor amount. What constitutes an appropriate ceiling should be determined based on the facts and circumstances of each individual taxpayer. However, any taxpayer seeking a deduction in excess of the safe harbor amount will need to have proof that such a policy is appropriate and clearly reflects income.

For upstream companies, it is also important to note that final regulations have retained the existing treatment of Geological and Geophysical (G&G) costs. The regulations specify that a taxpayer must capitalize amounts paid to facilitate the acquisition of real property. While the regulations view G&G costs as inherently facilitative to the acquisition of real estate, upstream companies are not required to include these costs in the basis of real property, but rather amortize these costs over 24 months under IRC Sec. 167(h).

The final capitalization regulations provide much needed clarification regarding the treatment of costs paid to acquire, produce or improve tangible property.

Furthermore, the de minimis safe harbor election provides an avenue for taxpayers with accounting procedures in place to consistently expense amounts under the safe harbor amount. Taxpayers, especially those in the oil and gas industry seeking to utilize any of the provisions of these regulations, should consult with their tax advisor to assess individual facts and circumstances.

Oil and gas companies should understand the impact this issue has on their state tax returns, and to make sure they are claiming the right property costs to be expensed.

Mark Duffy is a manager of Tax Planning and Compliance Services with Whitley Penn, a CPA and Professional Services firm in Fort Worth. He has more than seven years of public accounting experience focused on planning, consulting and reviewing tax returns for mid-size businesses and individuals.

Duffy also has significant exposure to oil and gas taxation issues including state tax considerations, tax partnerships, deck/well revenue accounting.